3/12/2010 @ 12:01AM

America's Foreign-Owned National Debt

Virtually every budget expert knows that the U.S. federal debt is on an unsustainable course. This means that something beyond our control is eventually going to force us to live within our means. Historically, it has been foreign bond holders who ultimately imposed fiscal austerity on profligate nations. That is why America’s growing foreign debt should be a matter of concern to policymakers.

As is well known, the Founding Fathers were quite hostile to the idea of a national debt and deficit spending. The Constitution itself came into being because the federal government was institutionally incapable of balancing its budget, leading to a financial crisis and a constitutional convention to fix it. Yet, the framers of the Constitution neglected to include a provision requiring a balanced budget.

It’s possible that the framers thought it superfluous to have a provision explicitly stating that the budget should be balanced, since it was a view so widely shared by all Americans at the time. They also didn’t see any need to explicitly state that the Constitution guaranteed freedom of speech and religion and other important provisions that were subsequently included in the Bill of Rights.

It’s also possible that the Constitution’s restrictions on federal taxing power and the limited areas in which spending was permitted were viewed as sufficient to keep federal finances under control. For the most part, the framers were right; for the first 150 years or so of our nation’s history there was no need for an explicit balanced budget requirement. Generally speaking, the budget was balanced or ran a small surplus; deficits arose only during wars and were quickly paid off afterward.

A key reason why an implicit balanced budget requirement was maintained for so long is that the U.S. was a capital importer throughout the 19th century. It was bad enough, most Americans thought, to be dependent on European capital markets for the money needed to build railroads, canals and other important projects, but giving foreigners control over the government itself was unthinkable. At that time, U.S. capital markets were quite small, and any significant bond issue would have had to have been floated in London, Paris or Amsterdam, and denominated in gold, pounds or francs.

After World War I, however, the U.S. ended up holding much of the world’s gold, which had fled Europe for safety. The war also damaged European capital markets and made New York the world’s financial center. Henceforth, it was not difficult for the Treasury to finance any level of federal borrowing domestically. In effect, we owed the national debt to ourselves, thus reducing concerns about the political and economic impact of deficit spending.

Until the 1970s foreigners owned less than 5% of the national debt. This began to change after the big run-up in oil prices. As oil exporters suddenly acquired vast financial resources they found it convenient to park them in Treasury securities, which provided liquidity and safety. By 1975 the foreign share of the national debt rose to 17%, where it stayed through the 1990s, when China began buying large amounts of Treasury bills. At the end of last year foreigners owned close to half of the publicly held national debt.

Chinese ownership of Treasury securities is probably significantly understated. Press reports suggest that China may be using agents in London, Hong Kong and elsewhere to disguise some of their purchases in order to avoid political scrutiny. Economist Simon Johnson of MIT believes that the Chinese almost certainly own more than $1 trillion in Treasury securities.

How the Chinese came to acquire all these securities and what they might do with them is not well understood. It is primarily the result of their exchange rate policy, which fixes the Chinese currency to the dollar below the value that would exist if it were allowed to float freely. The Chinese do this because it makes their exports cheaper in terms of dollars, and imports from the U.S. more expensive in terms of their currency, which is a key reason for our large trade deficit with China.

To keep the Chinese currency from rising against the dollar, which it certainly would in the absence of intervention, the Chinese government uses its currency to buy dollars. This raises the value of the dollar and reduces the value of the Chinese currency on foreign exchange markets. In the process, the Chinese acquire vast amounts of dollars that they must invest in dollar-denominated assets. It suits the Chinese to put most of this money into Treasury securities for the same reason the Arabs did in the 1970s.

In short, the acquisition of Treasury securities by the Chinese is the necessary complement to their trade policy. As long as they insist on holding down the value of their currency to stimulate exports they have no choice but to buy large amounts of Treasury securities. If the Chinese stop doing so then their currency will rise against the dollar, which will make Chinese goods more expensive in terms of dollars and American goods cheaper in terms of Chinese currency.

It has been the U.S. position for some time that the Chinese should allow their currency to appreciate so as to redress the huge trade imbalance between our countries. But if the Chinese stop buying our bonds it will raise interest rates on Treasury securities. That’s probably why the Treasury never presses the Chinese too hard on this issue. However, economist Gary Burtless of the Brookings Institution believes that the increase in U.S. growth resulting from a decline in the trade deficit, which subtracts from GDP, would more than compensate for the increase in interest rates.

Further complicating the issue is the fact that the Chinese now own so many Treasury bonds that they are really in the position of being a company’s largest shareholder. If they dump their holdings, their price will necessarily decline, thus imposing a potentially large capital loss on themselves.

Moreover, the options for what the Chinese might do alternatively with all their assets are limited. If they buy non-dollar-denominated assets it will push down the dollar, which will frustrate their trade policy. And despite U.S. financial problems, Europe’s are worse, making euro-denominated bonds unattractive. If the Chinese try to buy American stocks, real estate or other assets they lose liquidity, take on risk and run up against all kinds of political objections. So unless they are ready to go on a buying spree for American goods and services, the Chinese are pretty much stuck.

The Chinese dilemma reminds me of a quip once made by economist John Maynard Keynes: “Owe your banker £1,000 and you are at his mercy; owe him £1 million and the position is reversed.” (The quote can be found in his collected writings, vol. 24, p. 258.)

This does not mean we should be complacent about the Chinese and other foreigners holding an increasing share of our national debt. For one thing, we are sending billions of dollars per year in interest payments overseas. Ultimately, that means an increasing share of the U.S. national income is being exported and enriching foreigners instead of Americans.

While I don’t worry too much about the Chinese using their Treasury holdings to bludgeon us into taking actions that are against our national interest, neither do I think the current trend is entirely healthy for both countries. The best solution would be for the Chinese to allow their currency to appreciate, which would go a long way toward redressing our trade imbalance, while we reduced our budget deficit enough to finance it domestically. Alternatively, we will have to be willing to accept broader Chinese ownership of private American assets–real estate, businesses and so on–which will certainly raise political tensions. It’s something both countries should seek to avoid.

As long as the U.S. national debt is entirely denominated in dollars, there is no risk that we will run into the sort of financial crisis that small countries often run into. What gets them into trouble isn’t the debt per se, but an inability to acquire sufficient foreign exchange with their own currency to service it. While the U.S. Treasury has never issued bonds denominated in foreign currencies, it is conceivable that it could be forced to do so if the dollar falls sharply and foreign demand for U.S. bonds wanes. That will be the point at which our debt problem becomes more than theoretical and we are really on the road to national bankruptcy.